Feb 3, 2014

Can Blindfolded Monkeys Really Beat the Stock Market?

The US Federal Reserveappears to be committed to sustaining its tapering strategy, meaning that the Fed is no longer providing financial support to bolster global capital markets. The markets' recent performance are reflecting the impact of that decision.

All of which raises, anew, questions about the role of cycles, randomness and the efficacy of professional investment managers.

Some academics, led by Professor Burton Malkiel of Princeton, have long advocated the existence of a 'random walk' factor in investment outcomes which suggests that 'a blindfolded monkey throwing darts at a newspaper's financial papers could select a portfolio that would do just as well as one carefully selected by experts.'

The Wall Street Journal ran an experiment for over a decade in which it matched the 'darts' versus the 'pros.' Its reporters played the role of blindfolded monkeys. The pros came out ahead, but the issue was not settled to anyone's satisfaction thanks to debates about risk and portfolio size which, antagonists argued, biased the outcome.

The Journal continued the contest informally until one participant appeared to win decisively, though it soon became apparent that he had taken advantage of a loophole in the rules ( a not-uncommon outcome in real life, let us aver). There were those who felt that this was cheating, or at least an unfair exploitation of the spirit of the contest.

But there was an important lesson in his strategy: as the following article explains, it mimicked almost exactly the approach taken by algorithmic or high speed computerized trading. Which should probably serve to inform us about the influence of technological and methodological impacts on such results in this economic environment. JL

Alex Mayyasi reports in the Priceconomics blog:

The clearest example of how finance professionals can perform better than random
chance: cheating, loopholes, and investing in ways impossible for the rest of
the market to match.

On Wall Street, the term "random walk" is an obscenity. It is an
epithet coined by the academic world and hurled insultingly at the professional
soothsayers. Taken to its logical extreme, it means that a blindfolded monkey
throwing darts at a newspaper's financial pages could select a portfolio that
would do just as well as one carefully selected by experts.

In his Princeton class, economics Professor Burton Malkiel once had
his students create charts of fictional stocks by flipping a coin. The stocks
started at a price of $50. Each day, the stocks either gained or lost fifty
cents in value depending on the coin flip.

As the class soon realized, their stocks’ “investment history”
looked realistic. Malkiel even showed one to a “chartist,” an investor who picks
stocks solely by analyzing stock market charts under the assumption that certain
patterns repeat themselves. Malkiel describes the analyst’s reaction:

One of the charts showed a beautiful upward breakout from an
inverted head and shoulders (a very bullish formation). I showed it to a
chartist friend of mine who practically jumped out of his skin. "What is this
company?" he exclaimed. "We've got to buy immediately. This pattern's a classic.
There's no question the stock will be up 15 points next week."

A random walk, referred to in the above quote from Malkiel’s
investment book A Random Walk Down Wall Street, describes movements
or changes (like the price fluctuations in Malkiel’s fictional stocks) that
follow no discernible pattern. Malkiel’s experiment asked whether Wall Street
analysts might be assuming an ability to detect patterns and predict stock
fluctuations that occur with all the logic of a coin flip.

Just as one day some primitive tribesman scratched his nose, saw
rain falling, and developed an elaborate method of scratching his nose to bring
on the much-needed rain, we link economic prosperity to some rate cut by the
Federal Reserve Board or the success of a company with the appointment of the
new president “at the helm.”

The random walk hypothesis does not mean that companies (and their
stock price) rise and fall randomly. The existence of persistently successful
investors like Warren Buffett suggests that long-term investments based on a
business’s fundamentals can pay off, and all investors can ride the slow, steady
upward trend of the market.

But the random walk hypothesis would mean that Wall Street types
delude themselves when day trading and trying to arbitrage short term
fluctuations in a stock’s price. It would mean that daily fluctuations are too
random to predict by a stock’s trading history or news announcements. All those
day traders -- by the random walk idea -- are simply confusing the signal for
the noise.

The Appeal of Man vs Monkey on Wall Street

If correct, the random walk hypothesis and its variants would mean
that an incredible number of well compensated investors are charlatans, charging
exorbitant management fees to invest individuals’ money no better than an
average mutual fund or a monkey picking at random. And as Malkiel writes, “financial analysts in pin-striped suits do not like
being compared with bare-assed apes.” But the idea has appeal for banker
bashers.

In 2010, a Russian circus monkey named Lusha picked an investment
portfolio that “outperformed 94% of the country’s investment funds” to great
acclaim. Given 30 blocks, each representing a different company, and asked
“Where would you like to invest your money this year?”, the chimp picked out 8
blocks. An editor from a Russian finance magazine commented that Lusha “bought
successfully and her portfolio grew almost three times.” He suggested that
“financial whizz-kids” be “sent to the circus” instead of rewarded with large
bonuses.

Lusha’s investment experience is not exactly ironclad proof of
Malkiel’s monkey challenge. But the question of whether monkeys could do the job
of financial analysts was picked up years earlier by no less stodgy an
institution than the Wall Street Journal.

The WSJ Dartboard Contest

The Journal did not use actual monkeys. Insurance concerns(and
probably office productivity concerns) robbed the world of that. Instead, staff
at the Wall Street Journal played the role of the chimps, throwing
darts at financial pages hung on the wall.

The monkey portfolio consisted of 4 stocks hit by the staffers’
darts, while 4 stock picks, each from a professional investor, made up the
competing portfolio. The Journal published the portfolios of each and
then compared the results -- at first a month later, then 6 months
later.

The Wall Street Journal Dartboard contest ran as a feature
in the paper forover a decade. But 14 years,
during which a number of academic papers investigated the contest results,
proved insufficient to settle the competition between man and monkey’s
investment prowess.

But in the end, after 142 six-month contests, the pros came out
ahead, racking up an average 10.2% investment gain. The darts managed just a
3.5% six-month gain, on average, over the same period, while the Dow industrials
posted an average rise of 5.6%. The pros also outperformed Wall Street
Journal readers, who were invited to join the fray in
1999.

Despite those statistics, not everyone agreed that the pros beat the
darts, and the same article declined to declare a winner. One reason why is that
professional investors barely beat the monkeys in the head to head results. As
Investor Home
reports on the results of the first 100 dartboard contests:

The pros won 61 of the 100 contests versus the darts. That’s better
than the 50%... [but] losing 39% of the time to a bunch of darts certainly could
be viewed as somewhat of an embarrassment for the pros. Additionally, the
performance of the pros versus the Dow Jones Industrial Average was less
impressive. The pros barely edged the DJIA by a margin of 51 to 49 contests. In
other words, simply investing passively in the Dow, an investor would have
beaten the picks of the pros in roughly half the contests (that is, without even
considering transactions costs or taxes for taxable investors).

Critics also pointed to problems with the contest that they charge
biased the results in favor of the pros.

Malkiel -- who threw the first dart at the start of the contest --
criticized the choice of a 4 stock portfolio. The small number of stocks
represented the non-rigorous nature of the competition -- the Journal
called the dartboard contest “light-hearted.” But Malkiel and fellow minded investors
advocate for a passive investment strategy of mutual funds that rise modestly
but consistently with the growth of the stock market. Picking only 4 stocks,
therefore, invalidates the blindfolded monkeys’ advantage.

From the start, Malkiel also complained that printing the investors’
stock picks would skew the results. Since the Journal published the
portfolios at the start of the contest, the paper’s 1.5 million plus subscribers
saw their recommended picks, bought them, and drove up the price. A paper in the Journal of Financial and
Quantitative Analysis confirmed this. The authors found that the
professional investors’ stock picks experienced unusually high returns and
trading volume in the days following publication, although the WSJ
extended the length of the contest from one month to 6 in order to mitigate this
concern.

But by far the biggest challenge to the professional investors’
victory over the darts was that the results did not account for risk, nor for
dividends. A number of academic papers (summarized here) found that the investors’ portfolios
were much more risky and paid out less in dividends than the stocks picked by
dart. As a result, the competition was less a fair fight and more a comparison
of apples to oranges. Or, in this case, US treasury bonds to technology
stocks.

Investing is a trade off between risk and reward; the choice of
seeking higher returns through riskier stocks (like technology companies) is an
investment decision -- not the mark of a savvy investor. A bond investor chooses
the safety of the U.S. government, which is still considered the safest
investment around, and its regular payouts. The technology investor, in
contrast, risks big losses during a new tech bubble or to the breakout of
competitors for the upside of larger gains in share price.

The dartboard contest took into account neither risk nor dividends.
Since the professionals chose stocks that paid out fewer dividends, the monkey
portfolio didn’t get credit for its dividend gains. And since the pros chose
riskier stocks, the dart picks didn’t get credit for being a safer investment.
In other words, the professionals’ higher returns were not necessarily the
result of savvier picks, but the expected result of choosing a riskier
investment strategy. Apparently entrusting your money to blindfolded monkeys is
a more conservative investment strategy than professional Wall Street money
managers.

Beating the Darts

Like many great debates, Malkiel’s challenge to professional
investors remains unresolved by experiments like the Wall Street
Journal’s dartboard contest. (Other academic papers simulated the thought experiment with random
number generators playing the role of blindfolded monkeys.)

From this author’s perspective though, the test still seems like a
moral victory for the blindfolded monkeys. As one
article on the contest notes, “We are talking about a contest that
originated from what was initially considered by many people to be an absurd
theory - that a primate could pick stocks as well as intelligent, well educated,
and highly compensated investment professionals.” Even if the monkeys did lose
on the scoreboard, the fact that so many investigations side with the monkeys,
and the fact that they came close, seems like a moral victory.

But one clear lesson did emerge from the dartboard contest. After
retiring the competition in 2002, the Wall Street Journal continued
letting readers compete with the darts. And in June 2013, one reader crushed the darts so thoroughly -- he turned his $100,000
into $5,541,631.87 to the darts’ $104,881.51 -- that his superiority over random
chance could not be disputed.

How did the well-named reader, Arthur Golden, do it? He cheated. Or
at least skewed the rules. As the WSJ wrote:

The real secret to his success was his clever exploitation of a
loophole in the game that made it distinct from a real-world trading scenario:
Because the virtual stocks sold for their last traded real-world price, Mr.
Golden was able to buy and sell large blocks of lightly traded stocks without
affecting the price of those stocks.

So he made six-figure profits off minute changes in stock
price.

In a kind of inversion of the high frequency trading performed by
Wall Street algorithms, Golden spent 5 hours a day arbitraging this loophole.
His huge victory reminds us of the clearest example of how finance professionals
can perform better than random chance: cheating, loopholes, and investing in
ways impossible for the rest of the market to match.

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As a Partner and Co-Founder of Predictiv and PredictivAsia, Jon specializes in management performance and organizational effectiveness for both domestic and international clients. He is an editor and author whose works include Invisible Advantage: How Intangilbles are Driving Business Performance.Learn more...